Prepping for a US Government Default

   11.21.13

Prepping for a US Government Default

This coming January 15, the US once again will bump up against its debt ceiling, and once again the acrimony among political factions in the US will probably push us to the very brink of a technical default on some short-term US debt payments. Such a default is highly unlikely, but even the most optimistic observers of our current political climate will admit that it could actually happen.

There’s a fair amount of disagreement out there on what the practical implications of a US default would be. On one end of the spectrum are optimists like newly minted Nobel laureate Robert Shiller, who has assured us that a US default “would not be the end of the world.” At the other end is the Organization for Economic Cooperation and Development (OECD), which has just issued a dire report detailing how a US default would usher in a calamitous financial crisis of Lehman-like proportions.

Opinions differ so widely in the impact of a US default because something like this has never happened before, ever. Prior to the advent of the US dollar as the world’s reserve currency, we had the gold standard. Yes, major world governments defaulted on their gold-denominated debts all the time. Heck, in the summer of 1971, even the US technically defaulted on its gold obligations. But what all of these gold-standard-era defaults have in common is that the value of the gold itself was never in doubt; an event of default was just about a sovereign’s ability to make a payment.

A US default would be different in that, for the very first time, the world’s most important reserve asset (the US Treasury debt that has displaced gold as the foundation on which the entire international financial system rests) would itself be in crisis. As I said above, depending on who you talk to, this may or may not be a big deal.

In this article, we’ll look at a four scenarios for how a default might play out, with an eye to preparing for them.

Note: None of the scenarios below involve a full-blown dollar crisis and hyperinflation, because I personally think that’s total nonsense. Sorry Austrians and goldbugs, but if you want to read a “Weimar, Part Zwei” type of story, with people burning wheelbarrows full of useless bills for warmth, then there are plenty of other places on the Internet where you can get your Peter Schiff on. Besides, a sudden, massive deflationary shock can give you all the doom and gloom you can stomach. Don’t believe me? Then read on.

The Optimistic Scenario

There’s a reason that a smart guy like Robert Shiller isn’t worried about the effects of a default on US treasuries, and that’s because the case for optimism here is actually quite strong. While it might technically qualify as an event of default, the failure of the US Treasury to make interest payments on some of the bonds it issues for a few days, weeks, or even months might not actually spook the credit markets the way that an an ordinary sovereign default would.

Things could hum along as normal because the credit markets might not actually call the solvency of the US into question, despite the missed payments. If you define “solvency” as strictly “the ability to pay back the money that you owe, plus the interest,” then the US can actually never be insolvent when it comes to repaying debt that’s denominated in US dollars. This is because we can magically just print more money to pay back our debts, thereby fulfilling the letter of our obligations, if not the spirit.

If this money printing is good enough to keep the credit markets happy, then those markets will respond to a string of late payments with the equivalent of “don’t worry about it, I know you’re good for it,” and it’ll be business as usual for the financial system.

Shiller and many other observers think that the markets will, in fact, tolerate a technical default for exactly this reason. Despite the troubles in Washington, they know that the US is always good for it, even if being “good for it” involves running the printing press a bit.

So if you want to prepare for the optimistic case, then just prepare to go on about your day as usual.

The Moderately Severe Scenario

A moderately severe reaction to a US default might look something like dot-com bust or the 1987 crash: the stock market takes a major dive, and the credit markets are thrown into turmoil.

The credit markets could actually believe that Uncle Sam is good for the money yet still start to deteriorate if, say, some significant number of oversized financial entities (banks or hedge funds) have made large, leveraged bets that a default will not take place. Or, maybe they haven’t placed an explicit bet on a non-default. Maybe all of the money on Wall Street is assuming that a default cannot ever happen so they’ve positioned themselves accordingly, much as they assumed that a major investment bank would never be allowed to fail back in 2008. After all, it wasn’t the fact that Lehman failed that really set off the Global Financial Crisis. It was the fact that everyone, to a man (and they’re still mostly men) knew that Lehman’s failure could not and would not happen. It was that certainty, along with the subsequent nasty surprise, that turned what would have just been yet another major financial crisis into a brush with Armageddon.

At any rate, when those big “no default” bets turn out to be bad ones and the banks and funds that made them get margin calls, then they could be forced to sell off assets in order to raise the cash to meet those margin calls. And that sell-off could begin to take on a life of its own, as such things sometimes do, with opportunistic short-sellers jumping in and driving asset prices down further so that the distressed entities need to sell even more of their rapidly deteriorating assets to raise the same amount of cash.

At some point, the credit market sees all of this forced selling into a falling market and begins to wonder who’s still solvent and who isn’t. The credit market may be confident that, despite its missed payments, the US is solvent, but what about those big banks or hedge funds that are rumored to be in trouble because of large bets that a default could not happen? Fear could drive up interest rates, and the stock market, seeing that money is suddenly a lot more expensive, could then really start to dive in a major way, further feeding the cycle of forced selling and insolvency.

In this case, there’s still not a lot of prepping to do, because in a moderately adverse scenario, the madness stops before things get truly disorderly. That’s why it’s moderately adverse, and not Doomsday. Why does the madness stop? I don’t know, and it’s not my job to figure such things out. Maybe Janet Yellen takes a page from Ben Bernanke’s famous paper on the Great Depression and literally begins dropping free money from helicopters in order to stave off a sudden, deflationary shock. Or maybe the damage is contained via bailouts of the affected institutions. Regardless, you would just treat this as your run-of-the-mill stock market crash and do whatever it is you did in 1987 or 2000. Maybe you stayed glued to your favorite financial news outlet and ate popcorn, or maybe you fondled your pearl-handled revolver as you watched the value of your 401-K plunge. Either way, don’t worry about going without basic services.

Doomsday

Now we get to the fun part. Imagine the scenario described above, but without the deus ex washingtona. If, as the OECD suggests could happen, another Lehman-level catastrophe follows a technical default on US debt, then there could be no way to stop this sucker from goin’ down (to borrow George W. Bush’s famous phrase).

Imagine the world as it was a few weeks after Lehman’s failure: frozen credit markets, a plunging stock market with no bottom in sight, and congress in lockdown trying to hammer out a deal. But this time, congress and the Federal Reserve are out of ammo. There is no monetary bazooka that Hank Paulson’s successor can brandish to calm the markets because the market knows that all the shots were fired back in 2008 and Uncle Sam is out of ammo. Interest rates can’t go any lower, and the more Austrian-minded congresspeople refuse to go along with any “helicopter money drop” plans for fear of triggering runaway inflation. So we’re out of options for stopping the contagion, and the only direction we can go is all the way to the bottom.

This would be bad. Real, real, real bad.

I’ll tell you what almost happened in 2008, and you can use that to infer what will happen in this scenario. Note that you didn’t hear any of these details on the news at the time because to actually spell this stuff out would have risked inciting panic in the streets. So what we got were vaguely ominous pronouncements about how “catastrophic” it would be to not pass TARP. Well, here’s what catastrophe looks like.

First, nobody goes to work, anywhere. The supermarkets close up, the chain stores, the malls, the post office — all of it just shuts down. Why would a credit crisis cause this? Well, ask yourself this: would you go to work if you hadn’t been paid in a week or two, and it didn’t look like you were going to be paid any time soon? This happens because the entire economy runs on short-term credit, and short-term credit was unavailable post-Lehman.

The short-term credit market, more popularly known as the “commercial paper” market, is how companies large and small, public and private, pay their bills, meet their payroll, and generally operate from week-to-week. These companies turn to the CP market for quick loans so that they can finance operations when they don’t have the cash immediately on-hand.

In layman’s terms, the CP market functions as a kind of corporate credit card for the entire business sector so that companies can continue to make payments for essential things despite not having enough cash in the bank at the moment. And when the CP market froze up entirely post-Lehman, it was as if the entire credit card system stopped functioning, which meant that corporations had to run on just the cash they had in the bank. For many of the largest companies, this wasn’t enough to keep the lights on very long, and if TARP hadn’t passed when it did, then they would have started closing their doors and sending employees home the next week. It was that dire.

Speaking of everyone’s credit card not working all of the sudden, everyone’s credit card would stop working. So would everyone’s debit card. There would be no way to get cash out of the ATM or the bank, so you’d be forced to live on whatever cash you had on hand, just like corporate America – that is, if you could find a store that’s still open where the employees have decided to work for free.

There’s also no food. Even if the supermarkets were still open, the entire interstate commerce system that ferries food and other goods around the country via ships and trucks runs on short-term credit. When those markets froze post-Lehman, we were very close to the point where the trucks would simply stop running, again, because there would be no money to pay the drivers.

There’s no gas for your car. The barges that carry tons of oil up the Mississippi River all run on credit of one type or another, as do the tanker trucks that take gas out to filling stations. When the credit dries up, so does the gas.

Finally, there would be no clean water coming out of your faucet. You might think it’s wacky that a credit market freeze could affect the water supply, but as Michael Lewis describes in The Big Short, municipal water purification systems all run on credit. They borrow money short-term to get the chemicals and other supplies that they use to turn wastewater back into drinking water. So if TARP hadn’t passed, it wouldn’t have been long before people in the cities began to run out of clean water.

At this point, I doubt I need to go on. Imagine a world with no cash, no open stores, no food, and no clean water, and that describes the not-quite-worst-case scenario that could come about as a result of a US debt default. Obviously, you would prepare for this by keeping a stash of cash on hand, along with enough food and water to last you for a few weeks, at least. You might also want to have access to some way to defend your stash, depending on where you’re located and how you feel about your fellow man.

All of this sounds pretty apocalyptic, so you’re probably wondering why I called it the “not-quite-worst-case scenario.” That’s because there’s another, even more awful scenario.

Nuclear doomsday

Take everything I described in the previous section, and then add in a critical mass of power plant workers who have gone home, so that the power grid begins to shut down. Maybe they went home due to lack of pay, or maybe they bailed in order to protect their families from the chaos in the streets. Would you keep showing up for work if your family were stuck at home without access to food or clean water?

As has often been pointed out by those warnings of the dire consequences of an electromagnetic pulse (EMP) attack on our power grid, many of our nuclear plants depend on a functioning power grid and access to water to keep from melting down. If the power grid is compromised as a result of a large-scale economic shutdown, where people in the critical infrastructure areas of our economy stop showing up for work, then we could have Fukushima times a few hundred.

Here’s Matthew Stein, from the link above:

Unfortunately, the world’s nuclear power plants, as they are currently designed, are critically dependent upon maintaining connection to a functioning electrical grid, for all but relatively short periods of electrical blackouts, in order to keep their reactor cores continuously cooled so as to avoid catastrophic reactor core meltdowns and spent fuel rod storage pond fires.

If an extreme GMD were to cause widespread grid collapse (which it most certainly will), in as little as one or two hours after each nuclear reactor facility’s backup generators either fail to start, or run out of fuel, the reactor cores will start to melt down. After a few days without electricity to run the cooling system pumps, the water bath covering the spent fuel rods stored in “spent fuel ponds” will boil away, allowing the stored fuel rods to melt down and burn [2]. Since the Nuclear Regulatory Commission (NRC) currently mandates that only one week’s supply of backup generator fuel needs to be stored at each reactor site, it is likely that after we witness the spectacular night-time celestial light show from the next extreme GMD we will have about one week in which to prepare ourselves for Armageddon.

At that point, I hope you have a boat and are near the ocean, because that’s the only way you’re going to get out of the northern hemisphere. And getting out of the northern hemisphere is the only way you’ll have even a small chance of surviving the large-scale, civilization-ending nuclear catastrophe that would ensue from a collapse of the US power grid.

Conclusion

The good news is, the two worst-case scenarios are massively unlikely. Our odds of actually defaulting any time in the next few years, while terrifyingly non-zero, are still relatively slim. And if we do default, there are a ton of smart economists and traders who are quite sanguine that nothing really bad will happen. I personally am in the “no big deal” camp, for what it’s worth.

But if you’re thinking that there’s a possibility that we may end up in a Doomsday scenario, at least for a few weeks or months, then three things that you absolutely must have on-hand are water, food, and cash. And if you’re certain that The End is nigh, then maybe you should think about buying a boat.

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